"Income Inequality and Regressive Taxes Lower Interest Rates, Helping Fiscal Capacity"

Ludwig Straub, Professor of Economics at Harvard University

“If a regressive tax system is introduced where tax rates decrease as income increases, it acts as a factor lowering nominal interest rates, thereby increasing the fiscal policy capacity. However, in countries like Japan with a ‘zero (0) interest rate,’ a progressive tax system must be implemented for government debt to remain sustainable.”

Ludwig Straub, a professor of economics at Harvard University, stated this on the morning of the 30th at the Bank of Korea in Jung-gu, Seoul, during the 2024 BOK International Conference held under the theme “Changes in the Neutral Interest Rate and Implications for the Global Economy.”

On this day, Professor Straub supplemented his recent research analyzing the conditions of a “free lunch.” The term “free lunch” refers to a situation where the government debt-to-GDP ratio remains unchanged even as the fiscal deficit increases. According to previous research, government debt can be sustained if the condition that “the nominal growth rate exceeds the nominal interest rate” is met. He explained, “However, if government debt accumulates and increases, stricter conditions are required to expand fiscal capacity because the required yield of government bond investors rises sharply.” When the supply of government bonds increases, bond prices fall and, conversely, bond yields rise.

He emphasized a stricter condition for the free lunch: “The gap between the nominal interest rate and the nominal growth rate must widen beyond the existing condition.” For countries with relatively high government debt, the gap between these two indicators must be even larger. This is because as the government debt ratio increases, the required yield of government bond investors also rises. This argument was derived through a model that includes not only fiscal and monetary policy (government) but also savers, consumers (households), and representative firms.

Professor Straub said, “The lower the social discount rate, the greater the income inequality, and the lower the degree of progressivity in taxation, the greater the fiscal policy capacity.” This is because the nominal interest rate falls, widening the gap with the nominal growth rate. The discount rate is the rate that equates future value with present value; a lower social discount rate increases future value. This leads to reduced consumption and increased savings. As the demand for savings rises, interest rates fall, and the gap between the two indicators widens.

Income inequality and regressive taxes also lower nominal interest rates. As the demand for government bonds from high-income groups increases, bond prices rise and bond yields fall. This widens the gap between nominal interest rates and nominal growth rates. In societies with severe income inequality, high-income groups have greater incentives to purchase government bonds, causing nominal interest rates to drop further. The tax system works similarly. Under a regressive tax system, the demand for government bonds from high-income groups increases. This is why governments adopting regressive rather than progressive taxes have relatively greater fiscal capacity.

However, in cases like Japan where the benchmark interest rate is at the ‘zero (0)’ level, the situation changes. Unlike the previous scenario, the higher the income inequality and the lower the degree of progressivity, the more the government’s fiscal policy capacity decreases. Professor Straub noted, “Nominal interest rates are already close to zero. Fiscal stimulus through deficit spending can increase the nominal growth rate and ultimately reduce the debt ratio.”